Decision theory

Introduction
• Decision making is an integral part of any business organization.
• The process involves selecting the best among several decisions through a
proper evaluation of the parameters of each decision environment.
 The Six Steps in Decision Theory

• Clearly define the problem

• List the possible alternatives

• Identify the possible outcomes

• List the payoff or profit of each combination of alternatives and

outcomes
• Select one of the mathematical decision theory models

• Apply the model and make your decision

 Types Of Decision Making Environments
• Type 1: Decision Making under Certainty.

Decision maker know for sure (that is, with certainty) outcome or
consequence of every decision alternative.
• Type 2: Decision Making under Uncertainty.

Decision maker has no information at all about various outcomes or

states of nature.
• Type 3: Decision Making under Risk.

Decision maker has some knowledge regarding probability of

occurrence of each outcome or state of nature.
 Decision Making Under Uncertainty

• If the decision maker does not know with certainty which state of
nature will occur, then he/she is said to be making decision under
uncertainty.
• The five commonly used criteria for decision making under
uncertainty are:

1. the optimistic approach (Maximax)

2. the conservative approach (Maximin)

3. the minimax regret approach (Minimax regret)

4. Equally likely (Laplace criterion)

5. Criterion of realism with  (Hurwicz criterion)

 Optimistic Approach
• The optimistic approach would be used by an optimistic decision
maker.
• The decision with the largest possible payoff is chosen.
• If the payoff table was in terms of costs, the decision with the largest
cost would be chosen.
 Conservative Approach

• The conservative approach would be used by a conservative decision

maker.
• For each decision the minimum payoff is listed and then the decision
corresponding to the maximum of these minimum payoffs is selected.
(Hence, the minimum possible payoff is maximized.)
• If the payoff was in terms of costs, the maximum costs would be
determined for each decision and then the decision corresponding to
the minimum of these maximum costs is selected. (Hence, the
maximum possible cost is minimized.)
 Minimax Regret Approach
• The minimax regret approach requires the construction of a regret
table or an opportunity loss table.
• This is done by calculating for each state of nature the difference
between each payoff and the largest payoff for that state of nature.
• Then, using this regret table, the maximum regret for each possible
decision is listed.
• The decision chosen is the one corresponding to the minimum of the
maximum regrets.
 Example: Marketing Strategy

Consider the following problem with two decision alternatives (d 1 & d2) and two
states of nature S1 (Market Receptive) and S2 (Market Unfavorable) with the
following payoff table representing profits ( $1000):

States of Nature
s1 s3

d1 20 6
Decisions
d2 25 3
 Example: Optimistic Approach

An optimistic decision maker would use the optimistic approach.

All we really need to do is to choose the decision that has the largest
single value in the payoff table. This largest value is 25, and hence
the optimal decision is d2.

Maximum
Decision Payoff
d1 20
choose d2 d2 25 maximum
 Example: Conservative Approach

A conservative decision maker would use the conservative approach.

List the minimum payoff for each decision. Choose the decision
with the maximum of these minimum payoffs.
Minimum
Decision Payoff

choose d1 d1 6 maximum
d2 3
 Example: Minimax Regret Approach

For the minimax regret approach, first compute a regret table by

subtracting each payoff in a column from the largest payoff in
that column. The resulting regret table is:
s1 s2 Maximum

d1 5 0 5
d2 0 3 3 minimum

Then, select the decision with minimum regret.

 Example: Equally Likely (Laplace) Criterion

Equally likely, also called Laplace, criterion finds decision

alternative with highest average payoff.
• First calculate average payoff for every alternative.

• Then pick alternative with maximum average payoff.

Average for d1 = (20 + 6)/2 = 13

Average for d2 = (25 + 3)/2 = 14 Thus, d2 is selected

 Example: Criterion of Realism (Hurwicz)
• Often called weighted average, the criterion of realism (or Hurwicz)
decision criterion is a compromise between optimistic and a pessimistic
decision.
– First, select coefficient of realism, a, with a value between 0 and 1.
When a is close to 1, decision maker is optimistic about future, and
when a is close to 0, decision maker is pessimistic about future.
– Payoff = a x (maximum payoff) + (1-a) x (minimum payoff)
In our example let  = 0.8
Payoff for d1 = 0.8*20+0.2*6=17.2
Payoff for d2 = 0.8*25+0.2*3=20.6 Thus, select d2
 Example 2
Decision Making without Probabilities
Decision situation: An investor wants to decide which of the three property to buy.

Payoff Table for the Real Estate Investments

Decision-Making Criteria:
Maximax, Maximin, Minimax, Minimax Regret, Hurwicz,
Equal Likelihood (Laplace)
 The Maximax Criterion

In the maximax criterion the decision maker selects the decision that will result in
the maximum of maximum payoffs; an optimistic criterion.

Payoff Table Illustrating a Maximax Decision

 The Maximin Criterion

In the maximin criterion the decision maker selects the decision that will reflect the
maximum of the minimum payoffs; a pessimistic criterion.

Payoff Table Illustrating a Maximin Decision

 The Minimax Regret Criterion

Regret is the difference between the payoff from the best decision and all other
decision payoffs.
The decision maker attempts to avoid regret by selecting the decision alternative
that minimizes the maximum regret.

Regret Table Illustrating the Minimax Regret Decision

 The Hurwicz Criterion

- The Hurwicz criterion is a compromise between the maximax and maximin

criterion.
- A coefficient of optimism, , is a measure of the decision maker’s optimism.
- The Hurwicz criterion multiplies the best payoff by  and the worst payoff
by 1- ., for each decision, and the best result is selected.

Decision Values
Apartment building $50,000(.4) + 30,000(.6) = 38,000
Office building $100,000(.4) - 40,000(.6) = 16,000
Warehouse $30,000(.4) + 10,000(.6) = 18,000
 The Equal Likelihood Criterion

- The equal likelihood ( or Laplace) criterion multiplies the decision payoff

for each state of nature by an equal weight, thus assuming that the states of
nature are equally likely to occur.

Decision Values
Apartment building $50,000(.5) + 30,000(.5) = 40,000
Office building $100,000(.5) - 40,000(.5) = 30,000
Warehouse $30,000(.5) + 10,000(.5) = 20,000
 Decision Making without Probabilities

Summary of Criteria Results

- A dominant decision is one that has a better payoff than another

decision under each state of nature.
- The appropriate criterion is dependent on the “risk” personality and
philosophy of the decision maker.

Criterion Decision
(Purchase)
Maximax Office building
Maximin Apartment building
Minimax regret Apartment building
Hurwicz Apartment building
Equal liklihood Apartment building
 Decision Making under Risk (with Probabilities)
Expected Value (EV)

Expected value is computed by multiplying each decision outcome under

each state of nature by the probability of its occurrence.

EV(Apartment) = $50,000(.6) + 30,000(.4) = 42,000

EV(Office) = $100,000(.6) - 40,000(.4) = 44,000
EV(Warehouse) = $30,000(.6) + 10,000(.4) = 22,000
 Decision Making with Probabilities
Expected Opportunity Loss (EOL)
The expected opportunity loss is the expected value of the regret for each
decision.
The expected value and expected opportunity loss criterion result in the same
decision.

EOL(Apartment) = $50,000(.6) + 0(.4) = 30,000

EOL(Office) = $0(.6) + 70,000(.4) = 28,000
EOL(Warehouse) = $70,000(.6) + 20,000(.4) = 50,000
 Decision Making with Probabilities

Expected Value of Perfect Information (EVPI)

• The expected value of perfect information (EVPI) is the maximum amount a

decision maker would pay for additional information.

• EVPI equals the expected value given perfect information minus the expected
value without perfect information.

• EVPI equals the expected opportunity loss (EOL) for the best decision.
 Decision Making with Probabilities
EVPI Example

Decision with perfect information: $100,000(.60) + 30,000(.40) = $72,000

Decision without perfect information: EV(office) = $100,000(.60) - 40,000(.40) =
$44,000

EVPI = $72,000 - 44,000 = $28,000

EOL(office) = $0(.60) + 70,000(.4) = $28,000
Exercise 1
Consider the details of two competing alternatives as shown in the given table.
The initial outlay of each of the alternatives is Rs 10,00,000.The life of each
alternative is 10years. Find the best alternative, when the interest rate is 0%

Annual Revenue of Alternatives

Alternative 1 Alternative 2
Annual Probability Annual Probability
revenue (Rs) revenue (Rs)
3,00,000 0.3 4,00,000 0.1
4,00,000 0.4 5,00,000 0.5
5,00,000 0.3 6,00,000 0.4
 Decision Trees
• A decision tree is a chronological representation of the decision
problem.
• Each decision tree has two types of nodes; round nodes correspond to
the states of nature while square nodes correspond to the decision
alternatives.
• The branches leaving each round node represent the different states of
nature while the branches leaving each square node represent the
different decision alternatives.
• At the end of each limb of a tree are the payoffs attained from the
series of branches making up that limb.
Example 1
A contractor has a choice between two courses of action : a) A risky contract
promising Rs 10lakhs with a probability of 0.6 and Rs 6lakhs with a probability
of 0.4 b) A diversified portfolio consisting of two contracts with independent
outcomes each paying 5lakhs with a probability consisting of two contracts with
independent outcomes each paying 5lakhs with a probability of 0.6 and Rs 3
lakhs with a probability of 0.4. Construct the decision tree for using EV criteria.
What is the optimal decision by using EV criteria.
 Decision Tree

10
0.6

2
0.4 6
1
0.6 5

3
0.4
3
Cont.,
EV of node 2 = Rs [10 x 0.6 + 6 x 0.4]

= Rs 8.4lakhs

EV of node 3 = Rs [5 x 0.6 + 3 x 0.4]

= Rs 4.2 lakhs

The contractor must select a risky contract which will yield him maximum
return Rs 8.4 lakhs.
Example 2
A manufacture of a popular brand of refrigerator intends to market its new economy
model. It has three options namely:
i) to go ahead and launch
ii) to run a test market
iii) to abandon the model
If the product is a launched, the demand may be poor, good or excellent. Market
research conducted by a consulting firm indicates the probabilities of poor, good or
excellent demand as 20%, 40% and 40% respectively.
If a test market is used at a cost of Rs 2lakhs, it will give the indication of market being
either favorable or unfavorable, there being 50:50 chance of market being favorable and
unfavorable.
If the market response is favorable and the product is launched, the probabilities of
poor, good and excellent market are 10%, 20% and 70% respectively. And if the market
response is unfavorable and the product is launched, the corresponding probabilities of
poor, good and excellent market are 80%, 10% and 10%.
The payoff of the above categories of demand are Rs 4, 8 and 14 lakhs respectively.
Ignoring the expenses already incurred ( since they are irrelevant to the decision being
faced below) select an optimal decision to be taken now.
 e m and 4-0=4lakhs
r D .2
Poo 0
Launch the product Good 8-0=8lakhs
2
(0 lakhs) Ex0.4
cel
0.4 len
t 14-0=14lakhs

4-2=2lakhs
or
Po 0.1
0
Good
4 8-2=6lakhs
bl e Ex 0.20
r a ce
vo 0.5 0.7 llen
Fa e t 0 t
rk 14-2=12lakhs
Run a test Ma
1 3 U nf
(-2 lakhs) a vo
rabl o r 4-2=2lakhs
Mar e Po
ket 0
0.5 0.8
5 Good
Ex 0.10 8-2=6lakhs
ce
0.1 llen
0 t
14-2=12lakhs

To abandon the model 6

Cont.,

• EV of node 2 = Rs [ 4 x 0.2 + 8 x 0.4 + 14 x 0.4] = Rs 9.6 lakhs

• EV of node 4 = Rs [ 2 x 0.1 + 6 x 0.2 + 12 x 0.7] = Rs 9.8 lakhs
• EV of node 5 = Rs [ 2 x 0.8 + 6 x 0.1 + 12 x 0.1] = Rs 3.4 lakhs
• EV of node 3 = Rs [ 9.8 x 0.5 + 3.4 x 0.5] = Rs 6.6 lakhs

The EV of the alternative launch the product is 9.6 lakhs while that for run a
test is Rs 6.6 lakhs. Therefore, the optimal decision is to launch the product
Exercise 1
• In order to meet an increased demand for the product a manufacturing company is
considering three courses of action namely:
i) arrange overtime working ii) give subcontract iii) carry out expansion of the
existing unit.
The correct choice depends largely upon future demand which may below, medium
or high. The respective probabilities of the future demand are estimated as 0.1, 0.40
and 0.50. A cost analysis reveals effect upon the pay offs (profit) as shown in table
below:
The payoffs are in thousands of Rs
Demand Probability Courses of Action
Overtime Sub contract Expansion
Low (L) 0.1 -25 15 -180
Medium (M) 0.4 50 45 40
High(H) 0.5 80 55 160
Draw the decision tree and indicate the optimal decision and the corresponding
expected value.
 Exercise 2

A decision tree is a diagram consisting of decision nodes (represented as

squares), probability nodes (circles), and decision alternatives (branches).